Netflix Stock Volatility and Information Cascades
One place information cascades are very common is the stock market. In theory, the stock market is a form of “objective collective judgment” that values companies based on fundamental company actions. However, we see in practice that the stock market is much less rational, and is just as subject to ‘hype’ as any other fad. One famous example of this was the Netflix stock valuation between the beginning of 2010 and the end of 2011. Netflix’s stock was just one example of information cascades gone awry. In just under two years, the stock price rose from about $50 to almost $300. Then it’s value plummeted, losing over 74% of its value in the course of three months.
There are two rational reasons for information cascades, and why a person might simply follow the crowd instead of making decisions on their own: information based reasoning and direct benefit reasoning. Netflix’s volatile rise and fall exemplifies both types of information cascades. The stock price switched from being propelled by direct benefit, to being dragged down by information based information cascades. Direct benefit drove the stock price up as people who tried to short the stock kept losing to the ever-rising price per share. With no one shorting the stock, the price continued to rise – propelled by $30 million+ movie deals. People stopped shorting the stock, and just rode the price as it got higher and higher because it was more beneficial for them to do so. It was only nearly two years later, as the price slowly started to tip downward, that people began to short the stock. This was the transition from a direct-benefit to information-based cascade. Given more information, investors realized it wasn’t wise to shell out $30 mil for movies already available on pay per view, and recognized that the company was overvalued. With this newfound knowledge, investors slowly began to break away from the pack and shorted the stock, one by one, and then all at once, sending the stock price plummeting.
http://blogs.reuters.com/felix-salmon/2011/10/25/why-netflix-stock-is-so-volatile/